Governments need to adopt a mixed strategy of short-term and long-term measures to handle the crisis. The key is worldwide concerted action, based on similar policies executed by national governments. Some of the measures necessary have already been undertaken – but without the international coordination essential for their effectiveness.

It is obvious that dubious practices in the financial sector have gravely damaged the global financial system, with consequences for the rest of the world economy that are still hard to foresee. The Federal Reserve’s excessively low interest rates and the US government’s policy overactivism have contributed to an enormous loss of trust. European banks have been part of the problem, including public banks in Germany. Europe’s failure to provide early systemic responses has fuelled the fire. The reactions of the markets over the last ten days suggest that attempts to calm the markets and restore trust will not be effective in the short term. Therefore, the authorities need to adopt a mixed strategy of short-term and long-term measures to handle the crisis.

I believe that the key is worldwide concerted action, based on similar policies executed by national governments. In the short run:

Unsecured interbank lending has to be re-established by guarantees provided by the central banks and substituted by direct supply of liquidity and credits to the business sector by the Fed, the ECB, and others.

Providing a harmonised level of insurance for bank deposits is also essential.

Measures to recapitalise the banking system need to be taken – state funds might be one useful means to this end.

Central bank interest rates have to remain low and should be reduced further in Europe.

Banks should be allowed to value their assets at their purchase price and not their current market value.

Some of these measures have already been undertaken but without the necessary coordination.

The nationalisation of banks is a last resort to stop the crisis.

It is also essential to dampen expectations of an oncoming recession, since these have detrimental effects on consumer demand and investment spending. Higher public spending or lower taxes will not help to restore trust at this stage. Any fiscal stimulus needs to be timely, temporary, and targeted at those who are inclined to spend the money provided by the government. This is unlikely in the face of the current fear and distrust in the markets.

The stock markets are and will remain crazy and unpredictable until the architecture of a reinvented financial system comes into view. Regionally decentralised regulatory authorities are needed to supervise the entire financial sector including the hedge funds and the rating agencies. This would create incentives to compete for the best regulatory practice and to recognise systemic risk. It is necessary to refocus regulations on judging the global strategies of financial institutions. The regulatory authorities must also be enabled to supervise all aspects of the market participants’ activity including off-balance-sheet positions and the protection of investors. There is a need to abolish shareholder value as an indicator of success for the compensation schemes of managers. It is important to enforce the provision of sufficiently homogeneous and transparent assets. New financial products should be examined by the regulatory authorities and tested in a local market before they are accepted for general use.

Professor of Economics at Bonn University, Director of the Institute for the Study of Labor (IZA Bonn), President of the German Institute for Economic Research (DIW Berlin), and Honorary Professor of Economics at the Free University of Berlin. CEPR Research Fellow